Your
job on any given transaction is to analyze the target accurately and
negotiate the best deal for shareholders. You might like to think that
has everything to do with real cash flows and not much to do with
intangible assets and the accounting rules and standards for keeping
track of them. Wall Street, however, disagrees. The financial world is
keenly attuned to whether a deal is accretive or dilutive to your
company's earnings per share -- and now more than ever, getting the
intangibles right is key to setting and meeting Wall Street's
expectations.
There are two reasons for this. One is the profound shift in U.S.
balance sheets away from physical assets and toward intangible capital
such as brands, know-how and technology. In 1975, more than 80 percent
of stock market value related to hard assets; in 2006, the figure was
less than 20 percent, according to one study. The other is the advent
of two new standards from the Financial Accounting Standards Board
(FASB). Statement of Financial Accounting Standards (SFAS) 157, which
governs Fair Value Measurements, becomes effective November 15, 2007
(or January 1, 2008 for calendar year-end filers). SFAS 141R, which
deals with business combinations, may take effect in 2009.
These new standards represent another nail in the coffin for book
value reporting as financial reporting standards continue to call for
increased disclosure and transparency. The FASB's focus on fair value,
alongside regulators' expectation that more value be ascribed to
specifically identified assets than dropped into a catch-all bucket
called "goodwill," mean it's more important than ever to measure the
value and P&L impact of intangible assets early in a deal's
evolution. Doing so, however, is still the exception. Many dealmakers
today shortcut the early analysis by applying percentages of goodwill
and intangibles to purchase price based on other transactions they have
worked on.
But the most proficient acquirers are already placing more emphasis
on recognizing and disclosing intangibles. The advantages they gain are
easy to identify:
Better accretion-dilution analysis. First and foremost, the
amortization of intangibles will affect future earnings. Accurately
identifying which intangibles will amortize over what period of time is
an essential input to your accretion-dilution model. Grossly
underestimating the value or overestimating the life can result in an
unpleasant surprise: having bravely announced to the Street that the
deal will be accretive within the first year, your CEO may find herself
going back on her statement when the purchase price allocation is
completed post-close. Conversely, overestimating the amortization
expense could cause a deal team to second guess an otherwise attractive
target. Getting this right up front may also lead you to consider
different deal terms -- for example, deferred or lower consideration or
revised definition of the target -- to mitigate some of the early
dilution risk.
We've also seen cases in which a company has failed to think through
the full roster of potential intangibles only to be informed by its
valuation advisor, auditor, or the SEC after the ink has dried that it
may have missed a material one. No two deals are alike, so it pays to
revisit your fundamental assumptions, particularly when acquiring a
target slightly outside your comfort zone.
| Assessing intangibles |
| What to do and how to do it at each stage of the deal |
| |
Pre-letter of intent |
Due diligence |
Post closing |
|
Goal |
Develop initial bid and identify specific areas for diligence |
Identify unique circumstances and populate accretion/dilution model |
Book fair values and quarterly amortization expense |
|
Tools & techniques |
• Industry rules of thumb
• Benchmarking data
• Discussion with valuation advisers |
• Industry rules of thumb, rationalized against prior deals or own operations
• High-level models, with attention to key uncertainties |
• Multiple valuation approaches
• Replace placeholder assumptions with hard data
• Involve audit team |
|
Source: Authors |
| Industry-specific intangibles |
|
Banking |
Core deposit intangible:
Low cost source of funding relative to alternative market sources |
Purchased credit card relationships:
Future profit associated with existing cardholders |
|
Software |
In-process research & development:
A project not past technical feasibility stage that is expected to generate future profit |
Technology:
Platform for generating future earnings |
Subscriber relationships:
Expectation of future revenue from existing subscribers |
|
Manufacturing |
Supplier contracts:
Additional
profit above (or below) current market rates for the same services or
products; or, in the case of at-market contracts, the potential cost to
replace the contract |
Backlog:
Presold product or service that hasn't yet been converted to revenue |
Source: Authors |
Strategic insights. The presence and magnitude of a
business's intangible assets can offer clues to where the intrinsic
value of the company resides. For example, learning that an asset
management business has customer relationship values higher than
industry norms describes the strength of its client base and stability
of its revenues. Alternatively, if a software business's in-process
research & development is lower than typical, you might expect to
see higher patent or license values reflecting a different stage in the
company's life cycle or business model. Identifying and valuing the
target's intangibles provides a helpful sanity check: Do the implied
values match up against the reasons we are buying the business? Keep in
mind, the implementation of SFAS 157 will require even more disclosure
around the intangibles you ultimately book. Key assumptions -- for
example, trademark life -- could force you to show your strategic hand
earlier than you may have liked.
Anticipating impairment risk. Depending on the M&A
environment and the nature of the target, the acquirer may be forced to
pay a high premium over book value. While not bad in and of itself,
high levels of goodwill can create future impairment risk, depending on
the reporting unit structure the acquirer chooses. It also creates an
administrative burden of having to conduct annual impairment tests in
accordance with SFAS 142.
Simply put, reporting units represent the level at which management
actually manages its business. Modifications to reporting unit
structures must be disclosed with a business rationale and thus, cannot
be altered simply to satisfy financial reporting goals of a given deal.
Nonetheless, acquirers should be aware of current and future
implications as they relate to annual goodwill testing. For example, if
the target will be placed into a new reporting unit, a large amount of
goodwill could present future impairment risk in its annual testing if
business conditions change -- particularly if you aren't as familiar
with the ebbs and flows of the target's market conditions.
In other cases, an acquisition can create the impetus for a company
to restructure its reporting units. For example, a company may acquire
a new product line which enhances the importance of legacy ones. In
this case, management may seek to carve the existing product lines into
a new reporting unit along with the newly acquired business. Where in
the past the existing reporting unit had sufficient cushion to cover
downturns in market value, the shuffling of the deck could leave
goodwill in the legacy reporting unit exposed.
Another goodwill consideration is market perception. Flash back to
the Time Warner-AOL deal, which led to a $54 billion goodwill
impairment in 2002. A write-down is often construed as a mismanagement
or overpayment and not surprisingly, research has shown a clear
correlation between the magnitude of goodwill write-downs and decreases
in the acquirer's market value. In frothy M&A markets, it may be
virtually impossible to avoid at least a moderate level of goodwill.
Nonetheless, management would be well served to understand the fine
line between the immediate earnings impact of amortizing specific
intangibles on one hand and the future impairment risk of large amounts
of goodwill on the other.
Clearly, the advantages of analyzing a target's intangible assets
early in a deal are significant. So what should you consider in a
preliminary analysis? To answer that, let's take a closer look at what
these assets really are and how you go about valuing them.
Intangible assets are assets that are not physical in nature but
have an economic benefit associated with them. In general, they are
readily identifiable and can be separated and transferred to another
entity -- although facts and circumstances specific to a given
transaction may surface (or eliminate) potential candidates. Some are
found in many kinds of companies; others are more industry-specific
(see box, page 1).
Common intangibles include trademarks and brand names; customer
relationships; in-process research and development; software and other
technology; patents, licenses, and copyrights; leasehold agreements;
noncompete agreements; and other kinds of assets.
An assembled work force, we should note, is not recognized as an
intangible asset apart from goodwill under SFAS 141. However, it may be
valued in order to calculate a contributory asset charge or "rent" for
its use applied as part of the analysis of other assets.
Two elements should be considered in an intangible asset
analysis: value and life. Each asset has a value that represents the
economic benefit of holding that asset. The useful life associated with
it is the period over which the asset is expected to contribute to
future cash flow.
There are three common methods for determining the value of the
intangible asset -- income, cost and market. The income approach, the
most frequently used, estimates value based on expected discounted
future cash flow generated by the asset. A common example is the
customer relationship asset which contributes cash flow to a company by
virtue of the "stickiness" of the customer rather than a contractual
obligation. A variation of this approach is the "relief from royalty
method," which estimates the value of an asset (e.g., trade name) based
on royalty costs avoided by owning the asset.
The cost approach values the asset based on the cost to either
reproduce or replace the asset. Obsolescence and depreciation also
factor into the analysis. This approach is most applicable to value
assets that can be readily substituted. In addition, the cost approach
is applicable to estimating the value of the asset under the premise of
continued use, since if the holder did not own the asset, he or she
would have to substitute the asset and incur the costs of recreating
it. As an example, proprietary non-revenue generating software may be
valued in this manner.
Finally, the market approach attempts to identify the value of an
asset using analogs based on similar assets or comparable transactions.
This approach is appropriate when there is market data available and
sufficient information about the analog's context in order to make a
full comparison. Federal Communications Commission licenses such as
television or radio broadcast licenses may be valued using the market
approach.
The estimated remaining life of the asset is the other side of the
intangible coin. As a starting point, the remaining useful life should
be considered indefinite unless legal, regulatory, contractual,
competitive, economic or other factors limit its useful life. Note,
however, that the term indefinite does not mean infinite. A
finite-lived asset will be amortized straight-line or in some other
manner representative of its economic pattern of use, while an
indefinite-lived asset goes unamortized and is tested annually for
impairment.
How you approach identifying and valuing these assets will vary
depending on where you are in a given transaction, with the key factors
being how much access you have to data at that point and the level of
precision required. To get an idea of what you should be doing at each
stage, see the guideposts on page 1.
Some final notes about the impending accounting standards are in
order. SFAS 157 and SFAS 141R (as proposed) will have implications on
how you analyze deals and the types of deals you ultimately strike.
These standards introduce new concepts and guidelines surrounding fair
value measurement, with the hopes of increasing transparency of the
balance sheet. While the new standards cover far more than the
valuation of intangibles, the implications for these assets in
particular are far-reaching. Here are a few things to keep in mind
about each.
SFAS 157
• Highest and best use -- Fair value should be estimated using a
"highest and best use" framework as opposed to current or intended use.
An example of this is land now being used as an amusement park that has
higher realizable value as a condo development.
• Defensive value -- The defensive value premise, a new concept
introduced in SFAS 157, would indicate that even if the acquirer
doesn't intend to use an asset, it may have defensive value and should
therefore be valued and booked. Trade names are examples of assets that
could be deemed to have defensive value.
SFAS 141R
• Transaction costs -- Transaction costs would be expensed up front
under SFAS 141R as opposed to amortized over the length of the related
benefit (e.g., transaction costs related to a financing arrangement).
This means instant EPS dilution and will likely impact how deals are
financed, structured and, ultimately, priced.
• Contingent consideration -- The new standard calls for valuing the
earn-out liability up front (counter to the rationale for setting up an
earn-out in the first place) and each reporting period revaluing and
adjusting it as paid. This could affect day 1 goodwill for back-loaded
transaction structures, making earn-outs less attractive.
A full analysis of intangible assets is impractical in a deal
context. But just as you can never be certain you uncovered all the
potential risks in a deal, that doesn't mean you shouldn't consider
them at all. On the contrary: identifying, sizing, and anticipating the
amortization of intangibles should be an essential component of your
transactional decision-making. Be assured, if you're not thinking about
them, investors certainly are. - Sara Elinson and Joseph Sollitto
Sara Elinson is senior manager and Joseph Sollitto is an
associate in the valuation services practice of Deloitte Financial
Advisory Services LLP. The views expressed in this article are those of
the authors and do not necessarily represent those of Deloitte
Financial Advisory Services LLP.
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